Blockchain and cryptocoins: how cryptocurrency worksPosted on: May 10, 2022
by Ruth Brooks
Cryptocurrency may initially seem confusing to people, but it’s essentially just a digital, decentralised form of money.
Because it’s a digital currency, all transactions happen online rather than via physical notes and coins. Funds, or digital assets, are stored in digital wallets and public ledgers, and by operating on a peer-to-peer system, anyone, anywhere, can send and receive cryptocurrency payments.
What makes cryptocurrency different?
When comparing cryptocurrency to traditional currencies, such as the British pound or the U.S. dollar, there are a few key things to keep in mind:
Cryptocurrency – or crypto – is underpinned by a unique form of encryption. This is because cryptocurrencies are completely decentralised, so they don’t rely on a central bank or other authorities to verify transactions. Instead, transactions are verified using cryptocurrency encryption techniques called cryptography, which prevent counterfeit cryptocoins, double-spending, or other forms of manipulation or interference.
Crypto is reliant upon blockchain, which is an electronic database that holds huge amounts of information in groups known as blocks. These blocks are distributed across multiple computers, which is known as a distributed ledger, and when a block reaches its storage limit, it is connected – or chained – to another block. The process then begins again with a new block.
This technology is the backbone of crypto. A cryptocurrency’s funds, transaction records, and so on are shared across a distributed public ledger, and are made immutable, more efficient and more secure by blockchain.
It’s important to remember that blockchain is a specific type of distributed ledger – the two things are not synonymous. So while blockchain is a type of distributed ledger, a distributed ledger is not a blockchain. Similarly, cryptocurrency and blockchain are not the same thing. While cryptocurrency relies upon blockchain, blockchain can support a huge array of technologies in addition to crypto.
The monetary units of a cryptocurrency – crypto coins – are created and circulated by a process known as mining. Crypto mining is a process that effectively maintains and secures the cryptocurrency itself: miners validate transactions, add them to and update a blockchain’s distributed ledger, and protect against manipulation, double-spending, and so on.
This work requires sophisticated computer hardware and software that can solve cryptographic mathematical equations. To incentivise miners, new crypto coins are generated whenever one of these equations are solved, and then awarded to the solver. The process then begins again, with miners racing to solve the next equation.
Key to this work are the consensus mechanisms that verify transactions, add them to the blockchain, and create new tokens. The two largest consensus mechanisms are proof-of-work and proof-of-stake. Proof-of-work will reward any miner with crypto, while proof-of-stake is a bit more complicated. Generally speaking, though, it uses a network of validators who stake their own crypto for the opportunity to update the blockchain. The most invested participant will be selected by the network to validate the latest block of transactions, and other validators can confirm the accuracy of the block. Once the blockchain has been updated, all participating validators are awarded in proportion to their stake.
Buying, storing, and spending crypto
Mining is one way of gaining cryptocoins, but the majority of people using cryptocurrencies tend to buy from cryptocurrency exchanges, as well as more traditional brokers, using fiat currencies like the British pound. There are a variety of cryptocurrency exchanges and each of them offer different currencies, wallet storage options, interest rates, and purchasing method options, and typically charge fees. Traditional brokers, meanwhile, typically offer lower trading fees, but fewer crypto features.
Purchases can be made with debit and credit cards, or through platforms like PayPal or Venmo. And once purchased, cryptocurrencies are then typically stored and spent using cryptographic wallets, and can be used at a small but growing number of technology and e-commerce sites. There are also instances of luxury retailers, car dealers, and insurance providers accepting cryptocurrency as payment.
If investing in cryptocurrency, it can also be useful to use tools like CoinMarketCap to track prices for crypto assets, as well as track market capitalisation, also known as market cap. Market capitalisation is the total value of all the coins that have been mined within the cryptocurrency.
Types of cryptocurrency
Bitcoin, also known as BTC, was the first cryptocurrency and it remains the one people are most familiar with. It pioneered the industry and blockchain technology, and remains the largest name in the crypto market. Launched in 2009, its inventor – or inventors – remains a mystery, although it’s been connected to the name Satoshi Nakamoto, a presumed pseudonym.
Following the release of Bitcoin, a number of different cryptocurrencies joined the market. These are known as altcoins – any crypto that isn’t Bitcoin – and include:
- Ether, or ETH, which also developed its own blockchain, called Ethereum. Ethereum is home to the majority of non-fungible tokens (NFTs) on the market, has the largest crypto ecosystem, and has developed hugely popular decentralised finance (DeFi) protocols for financial products and services.
- ADA, the internal cryptocurrency of the Cardano blockchain.
- Dogecoin, or DOGE, which is considered the world’s first meme coin due to its connection to the doge/shiba inu dog meme. It even inspired an Ethereum-based crypto alternative, Shiba Inu (or SHIB).
- XRP, which was launched by Ripple Labs, Inc., the organisation that developed the Ripple payment protocol.
- Binance Coin (BNB), which is the cryptocurrency issued by Binance Exchange, the largest cryptocurrency exchange in the world.
- Tether, or USDT, a cryptocurrency hosted by a number of blockchains, including Ethereum and Bitcoin’s blockchain.
- Litecoin, one of the first altcoins available on the cryptocurrency market.
- SOL, which uses the Solana blockchain.
- DOT, which uses the Polkadot blockchain.
- Monero, which uses a privacy enhancing, open source protocol to obfuscate transactions and ensure anonymity.
- Bitcoin Cash, or BCH, which is a fork of Bitcoin. Another Bitcoin fork is Bitcoin Gold.
Challenges in crypto
Cryptocurrency and the blockchain technology it relies upon are both incredible feats of technology, but they are not without their detractors.
- Price volatility. Crypto prices are unpredictable and can fluctuate wildly.
- High energy consumption. Mining activities use huge amounts of electricity, generating a carbon footprint that may be unsustainable.
- Criminal misuse. Because it is unregulated by traditional methods, there are instances of crypto being used for illegal transactions or fraud. One example is fraudulent initial coin offerings. An initial coin offering (ICO) is similar to an initial public offering (IPO) and is typically used as a way to raise funds for a new cryptocurrency venture. However, because of the unregulated nature of ICOs, many investors have been conned into contributing huge amounts of money to fake cryptocurrencies.
Tackling these challenges can make cryptocurrency more palatable and sustainable – on several levels – and it’s worth noting that there are already solutions in progress. One of these solutions is the introduction of stablecoins, which are cryptocurrencies that are bound to more conventional assets, such as fiat currencies, to help stabilise prices. For example, USD Coin is a stablecoin that is pegged to the United States dollar.
Uncover new applications for blockchain and crypto
Cryptocurrency is a significant user of blockchains, but it’s just one of many potential uses for the evolving blockchain technology. For example, smart contracts run on blockchain, and can securely and reliably automate and decentralise any agreement or transaction – not just financial ones. They can be used for health records and even voting systems.
There is huge scope for development within these growing technologies, and the 100% online MSc Computer Science at North Wales Management School can help you forge your path. This flexible master’s degree has a real-world focus, and is taught part-time so you can study around your current commitments and earn while you learn.